Friday, May 6, 2011

Why Are Business Prices So Volatile?

The mainstream finance industry equates price volatility with risk and believes the market to be efficient. That is, prices of stocks are fairly priced, and therefore the only way to generate higher returns is by taking more risk (i.e. buying stocks with higher volatilities).

Value investors, of course, not only reject the fact that the market is efficient (for a terrific essay on the subject by Warren Buffett, see here), but also find flaw with the definition of risk. To value investors, risk represents the potential that the underlying business is or becomes worth less than anticipated, and this is often times completely unrelated to a stock price's volatility. Value investors believe volatility could be caused by the market's general level of fear, supply/demand characteristics of various securities at particular points in time, and other psychological factors unrelated to the underlying business.

A study by Richard Roll has attempted to quantify the various components that comprise a given stock's volatility. His findings are depicted in the chart below:

According to Roll, company specific risks play only a very small role in a stock's volatility. If this information is accepted, it seems ludicrous to believe a stock's volatility - rather than the fundamental business/financial risk of the underlying company itself - is what governs an investment's risk level. Investor confidence, interest rates, and the stage of the business cycle all play far larger roles when it comes to volatility!

Value investors who take advantage of volatility, rather than fear it by equating it with risk, position themselves for market beating returns!


Anonymous said...

Seems like something is wrong with Roll's analysis. Judging from the pie chart, it looks like a very small (2%?) fraction of a particular stock's volatility is due to undiversified company-specific risk. Well if that were really true, why would investors diversify at all? Diversification can only reduce that 2% even more, which is pointless. Doesn't make any sense...

- aagold

Anonymous said...

The links come up as blank pages. Do you have another one?

Saj Karsan said...

Thanks Anon2, I have fixed the link.